Magazine

How Efficient Is That Company?

December 22, 2002

In today's tough business climate, many companies succeed by running financially efficient operations. That means they keep costs down--and reduce the need to borrow--by trimming their inventories and speeding up collections of what's owed them. "At the end of the day, all businesses need to sell stuff as quickly as possible and then turn those sales into cash," says Charles Carlson, contributing editor of Dow Theory Forecasts, an investment newsletter.

In this installment of The Fine Print, an ongoing series on analyzing financial statements, we'll help you figure out what numbers you need to pull from corporate documents to make your own assessment of how well a company is managing its inventory and receivables. Analyses of these critical assets can help identify investment opportunities as well as uncover positive and negative trends before they show up in the earnings statements (table, page 96).

You can obtain the necessary documents, the 10-Qs and 10-Ks, at the Securities & Exchange Commission's Web site, www.sec.gov. Remember to also check company Internet sites. Often, companies issue quarterly financial data on their sites weeks before they file that information with the SEC.

INVENTORIES

Begin by looking at inventory levels at Dell Computer (DELL). Long known for its efficient operations, the computer powerhouse builds to order, which allows it to keep inventories at a bare minimum. The nation's leading PC seller turns over, or depletes, its inventory every 3.8 days vs. 4.8 days a year ago. That key number is not usually spelled out, so you have to extract it from the data.

To get this figure, go to the income statement and start with the cost of goods sold. You'll find that below the sales or revenue line. Dell's cost of revenue--the company uses that term instead of "cost of goods sold"--was $14.4 billion in the past two quarters and further research would show $27.7 billion for the four quarters.

Then flip to the balance sheet, and under assets, look for the inventory figure. Take the inventory for the most recent quarter, $307 million, and for the same quarter the year before, $269 million, and average the two. Then divide that average, $288 million, into the cost of goods sold, $27.7 billion, and you get 96.2, which is the annual turnover ratio. Now, divide the number of days in the year, 365, by that ratio, 96.2, and that gives you 3.8. Roughly speaking, that means it takes Dell less than four days to turn over its entire inventory. (In the latest quarterly financial data Dell lists on its Web site, the company reports four days of inventory on hand. But this figure is calculated on a quarterly rather than annualized basis.)

Still, that's only a snapshot. What counts is whether the days-to-sell inventory figure is improving or deteriorating. So you need to repeat the calculation going back another four quarters, and then another four quarters after that. That way, you'll have three years' of data for comparison.

Next, you need to do a reality check, even if you've uncovered a favorable downtrend in inventories. Maybe goods are flying off the shelves because the company is slashing prices. Is this Dell's strategy? Go to the income statement again to find the gross profit margin, which is revenue less cost of revenue. The key here is to check the trend in gross margins as a percentage of revenue. You want to see steady or climbing profit margins. Shrinking margins may signal that the company is slashing prices to move goods. That's not the case here. Dell's margins have edged up to 18.2% as a percentage of sales in the quarter ended Nov. 1, from 17.6% the previous year.

What if there's an increase in days to sell inventory? You have to question why. Higher inventories are normal, say, if a company is planning to introduce a product. But if there's no such rollout in the cards, the increase could just indicate that unwanted goods are building up in the warehouses. That could presage price slashing or write-downs.

RECEIVABLES

A company may make its revenues and inventories look good by clearing the shelves. So you have to ask if the seller is getting paid in cash right away, which is good. Waiting for the money isn't as good since some of what's owed may never be paid. The key: Determine how many days, on average, it's taking to collect its accounts receivable, or what customers owe.

The process is similar to figuring out the number of days it takes to sell inventory. From the income statement, you'll need annual revenues; from the balance sheet, accounts receivable. As you did with inventories, take the latest quarter's receivables and the year-before quarter's receivables and average the two. With Dell, that's $33.73 billion in revenues divided by $2.482 billion in receivables to yield a turnover ratio of 13.59. This shows how many times the company turned over its receivables during the past 12 months. Divide the days in the year, 365, by 13.59, and you get 27 days. So as of the latest reporting period, customers took an average of 27 days to pay for merchandise, down from 32 days the year before.

The sooner a company gets its customers to pay up, the sooner it has the cash to pay salaries, supplies, and lenders. If a company's collection period is lengthening, it could signal trouble. It may mean the company is extending credit to boost sales, and that could be problematic if the buyers are strapped.

STACKING UP

It's not enough to simply examine how well a company controls inventory or collects receivables. Step back and look at how it stacks up to its rivals.

Ideally, you want to see that a company is shortening both the days of inventory it keeps on hand and its collection period. You may find that a company has been backsliding in these areas, or simply holding steady. For instance, roughly half of the companies in the Russell 3000 stock index saw a lengthening in days of inventory on hand and collection periods during the past year, notes Carlson of Dow Theory Forecasts. These are not necessarily worrisome if a company's rivals are in a similar or worse situation. By the same measure, a company showing improvement may not get much traction if its competitors are making greater strides.

Keep in mind that these efficiency measures apply largely to companies that make or sell goods. Service companies don't hold inventory, but you can use the accounts receivables formula to examine how efficiently they collect what's owed.

Sure, it takes work to ferret out the inventory and receivables ratios from financial reports. But getting a read on these figures may tell you things that revenue and profit reports won't. By Susan Scherreik